F402 In-Class Exercise

August 27, 2020

1. Warren Buffett has had a remarkable career investing in companies. In the case Warren Buffet,
2015, the author summarizes Buffett’s investment philosophy. Some of Buffett’s main tenets are
consistent with what you have learned in your finance classes. Some seem to be inconsistent. List
the main components below in the appropriate column:

Consistent with what you have learned
Time value of money is held paramount
Make sure you rate of return is higher than your
cost of capital
Always consider your opportunity cost when
selecting and investment
Intrinsic value through the discounting of future
cash flows with an estimated growth rate
Align the interests of the agents and the owners
Take the emotions out of investing – rely on
fundamentals and economic value
Measure performance by the gain in intrinsic
value
Inconsistent with what you have learned
EMH, Buffet is glad to have had thousands
graduate from B-School being taught this
Completely disregards GAAP (look at economic
drivers not accounting drivers)
Economic drivers add insight into the realities of
a company (IP, patents, copyrights, trade secrets)
Diversify responsibly, but not entirely. If you are
not ignorant on stocks then you do not need to
own such a vast portfolio across the market (i.e.
you do not need to own 30+ stocks)
Owning a few shares is not different to Buffet
than owning the whole company

2. Did the market view Berkshire Hathaway’s acquisition of GEICO favorably? How can you tell?

The market did look favorably upon the GEICO acquisition. Berkshire Hathaway shares increased
significantly, $609.60 to $25,400 over time post acquisition.

Additionally, other insurance companies rose on the news of the GEICO acquisition, State Farm,
Allstate, Progressive, etc.. signaling that the market looked favorably on the future prospects of
GEICO, thus, bolstering the insurance industry.

Analyst forecasts of dividends increased consecutively following the acquisition as well.

Additionally, in NPV terms, the value of BH increased by $718 million signaling that the market liked
the acquisition.

3. At the time of the acquisition, BH already owned 34.25 million shares of GEICO. The acquisition
involved BH purchasing the remaining 33.65 million shares of GEICO. Given that BH saw its market
 value increase by $718 million, what (implied) price is the market placing on GEICO in response to
the acquisition announcement?

718 = 34.25 (Pm – 55.75) + 33.65 (Pm – 70) = ~ $73 therefore the market is showing a higher implied
price on the deal.

4. Given your answer to 3, is “Mr. Market” behaving irrationally? Explain.

The market is not irrational, the market received an influx of new information and they are
recalculating based on the new packet of information believing that Buffet has more information
that he did and factoring that into the new increase in price. There were other market participants
that were already looking favorably as they had increasing forecasts on dividends paid.